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by Stephen Parezo

May 19, 2004 — There was a time when a stigma was attached to any business filing for bankruptcy that would send shock waves through the owners' families, the local business community and creditors. It was considered the kiss of death for a company because very few firms seemed to rise from the ashes of massive debts. But that's just not the case anymore. More and more businesses are relying on bankruptcy filings to give them a fresh start.

According to the American Bankruptcy Institute (ABI), IRS data shows that annual bankruptcy filings have increased from about 300,000 in 1980 to approximately 1.7 million in 2003. With 92% of all bankruptcies categorized as Chapter 11s, or business reorganizations, companies are often able to avoid going south thanks to this type of filing that allows them to play for more time as they reorganize. (See sidebar for the different types of bankruptcies that are available.)

No longer under the gun

While the ignominy that was once attached to it has largely disappeared, experts relate that filing bankruptcy seems to be a vital survival route for firms under the gun.

"More and more businesses recognize the validity of purpose of Chapter 11," said Roger Whelan, a resident scholar at ABI, and a former U.S. Bankruptcy Court judge. "They don't feel necessarily that lawsuits and defaults on secured loans are going to result in foreclosure and repossessions. Bankruptcy is recognized for what it is-a chance to reorganize."

Industry watchers point out that in most circumstances bankruptcy is a viable option for small businesses, "but the viability of the option is certainly threatened by the increased cost of the process. This could run from $50,000 to $100,000," said Bob Keach, chair of the bankruptcy practice group with the law firm of Bernstein, Shur, Sawyer and Nelson in Portland, ME.

Janice Murray, managing director of Amherst Capital Partners, an investment banking and turnaround consulting firm in Birmingham, MI, says that stigma or no stigma, it's never the deciding factor for small businesses filing for bankruptcy.

"The business side of things should dictate whether to file for bankruptcy," she said. "Bankruptcy is a legal issue. The best way to handle it is outside of the courts because it's a little quieter and there's a little less publicity."

Small businesses are a different animal

Analysts acknowledge that the small business sector is a difficult one to assess because their banking relationships tend to be guaranty and cash-based, and they are less likely to get in trouble with too much debt.

The brunt of financial problems experienced by small businesses stem "from succession, a family feud or change in the business climate that they're using," said Anthony Schnelling, founding member and managing director of Bridge Associates LLC. The company is a New York City-based turnaround management firm.

What Schnelling finds particularly upsetting in mom and pop enterprises is the very characteristic that makes them unique: when family businesses have done well the business becomes personally identified with them. So, when things go bad, these small companies "pour everything into the business and they lose everything."

This, asserts the turn-around specialist, makes small family businesses "a different animal."

Pay attention to danger signals

Few mom and pop shops are able to regain full strength once they've filed for bankruptcy. Yet, experts say many of these smaller firms might have been spared if they had paid attention to the danger signals.

Nowhere this is more evident than in a company's payroll "department." For many small businesses, payroll-related items are their highest expenses. With such complex items as labor costs, benefits, payroll taxes and garnishments, payroll operations can be thought of as an integrated railroad operation with a network of tracks all originating from this one central location. Problems that arise here are felt throughout the system.

One key warning sign is when payroll tax liabilities are not taken care of, either by the owner, the owner's employees or the outside service handling the payroll.

"You have to watch the tax obligations and make sure there is a mechanism in place so these monies are put aside and paid whenever they're due," ABI's Whelan explained.

This is especially true because even if the business closes its doors, the owners are by no means absolved from their payroll tax liabilities. "When you file for bankruptcy, the tax obligations are going to continue and are not going to be discharged," he added.

One sure-fire recipe for disaster is to delay remitting payroll taxes to the authorities to catch-up on other mounting bills. Since there usually is a time lag before the agency's enforcement division steps in, the business doesn't feel any great need to make sure taxes have been paid.

Some small business owners even "get the mentality that they're really borrowing from the IRS," Whelan said. But once the administrative levy is assessed on them by the IRS, the next stop for the debtor (company) is filing for bankruptcy.

Watch out for cash flow problems

Another key indicator of a company entering dangerous financial waters is when checks start to bounce.

"That's the first sign of trouble-when you don't get paid on time," said Carol Rego, Payroll Manager for Fiducial's Payroll Processing Center.

Rego says the small business owner would usually be notified right away by his bank so he would know if there were any problems with the firm's account.

"If he's that far overdrawn they would send him something immediately if the employees aren't telling him about this already," she added.

But that doesn't necessarily mean that the company ship is headed for the rocks.

In many instances, Rego says the temporary glitch could be due to a cash flow problem. If an employer does a lot of contract work, they could be expecting a big check anytime soon while the next job is already underway and things get a little tight for a short period.

Bill Duvall, a business advisor with Fiducial in Manassas, VA, indicated that one of the telltale signs of bankruptcy is "having a cash flow problem on a consistent basis." He said this could lead to, in some states like Virginia, to having involuntary bankruptcy imposed by creditors, rather than the debtor, filing the bankruptcy petition for debts of $5,000 or more.

Accountants can help read the warning signs

In addition to the expense side, small business owners need to know where their revenue stream is going and if their profit margin has changed favorably and why. Unfortunately, most small business owners don't have the business acumen to scrutinize these crucial areas and do not take the time to do so.

That's why it's essential for most small businesses to have an outside accountant who will not only be the first one to read the warning signs on revenue and expenses but has the professional knowledge to counsel the company and determine whether the company should seek legal help.

Former bankruptcy judge Whelan cited an example of a troubled company that may have IRS liens on its property and is faced with closing its doors. Even though the IRS has a lien as a secured creditor, a 1980s Supreme Court ruling held that as long as the debtor still has title rights to the property, the debtor can control the property. An experienced professional can guide the company into setting up a bankruptcy estate where the property can be transferred and the estate managed better to pay off creditors more favorably.

Some financially-strapped firms have a tendency to either push the panic button and file for bankruptcy at the first sign of trouble or hold unrealistic expectations that things will improve and relief will arrive in the nick of time to avoid the legal route.

"There has to be that balance," he said. "There's such a thing as rushing in ill-advised or waiting too late for a miracle."

Education vs. reforms

The credit industry, meanwhile, is fighting for bankruptcy reforms but it's not even on the Congressional agenda, according to ABI's Whelan.

Supporters cite rising consumer debt and growth in abusive filings but ABI's study on this issue revealed that abusive filings account for just 3% of the total filings. Opponents charge that reforms are not only unnecessary but will pose a tremendous burden on those who have to supervise the filings, making it unnecessarily difficult for eligible businesses to seek relief.

For many diverse parties dealing with insolvency issues, perhaps the most important aspect about bankruptcy is trying to educate debtors.

"The problem is basically that debtors are euphoric in their outlook," Whelan added. "Small business owners not only need immediate access but ongoing supervision because if an emergency comes up, then it's too late."

Stephen Parezo is the Media Manager for Fiducial.

Whatever your small business needs, your Fiducial tax and financial professional can analyze your situation and recommend an appropriate action plan. To locate a Fiducial office nearest you on fiducial.com, see the Zip Code Locator located in the upper right hand corner of the page. Do you have a particular topic that we should be writing about that can help your business? Please send your suggestions to: stephen.parezo@fiducial.com.

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